An individual retirement account is a sweet deal, so it shouldn’t be a hard sell.
Salary reduction plans like 401(k)s are a great way to invest for the future, and if you’re eligible to participate in one, you should probably be putting money in.
But what if you don’t have access to such a plan right now? Maybe you’re freelancing or working for yourself, or your employer doesn’t offer a plan.
Perhaps you have to wait a year to qualify to participate, and you want to start putting money away sooner. And even if you are part of a plan, you may be looking for a way to invest more than the cap on what you can contribute.
As long as you earn income, you can contribute to an individual retirement account (IRA). There is a cap on what you can invest—$5,500 in 2018. You don’t pay current income tax on any earnings your investments produce and you can trade within the account without owing capital gains tax on any increases in investment value. But you’re likely to have transaction costs.
OPENING AN ACCOUNT
You can set up an IRA with a bank, a brokerage firm, a mutual fund company, or just about any other financial institution. All you have to do is fill out some simple paperwork and deposit your money.
CHOOSING YOUR IRA
Once you’ve chosen an IRA custodian, your next decision is the type of IRA you’ll open. A traditional tax-deferred IRA is always available. Beyond the requirement that you have earned income, there are no barriers—not even the fact that you may also be contributing to an employer plan. Doing one doesn’t prevent you from doing the other. You contribute after-tax income and pay no tax on any earnings in the account until you withdraw them. Withdrawals aren’t required until you’re 70.
You may be able to deduct your contributions to a tax-deferred IRA under certain circumstances. In that case, you reduce your current income by the amount of the contribution, earnings are tax deferred, and you pay tax on both contributions and earnings when you withdraw. You qualify either by not being covered by an employer’s retirement plan or by having an adjusted gross income (AGI) that’s less than the annual cap that Congress sets.
A tax-free Roth IRA differs in anumber of important ways from its tax-deferred siblings. You can never deduct your contribution, but no income tax is due on withdrawals after you turn 59., provided your account has been open at least five years. And if you don’t want to withdraw, you don’t have to.
To qualify to contribute to a Roth IRA in 2018, your MAGI must be $120,000 or less for a full contribution if you’re single and $189,000 or less if you’re married and file a joint return. Eligibility phases
out at $135,000 for singles and $199,000 for joint filers.
WHICH ONE FOR YOU?
If you’re eligible for all of the IRA alternatives, which one is right for you? What you need to weigh is the advantage of a tax deduction now—which puts a little more cash in your pocket—or the prospect of tax-free income thirty or more years in the future. Either way, you’ll have retirement savings, which is the most important reason to contribute to an IRA.
The power of compounding has the potential to produce big balances if you contribute the maximum to your IRA each year, starting right now. For example, a $5,000 contribution each year for 40 years would grow to more than $1 million with an average annual return of 7%.
Remember, too, that when you choose an IRA you aren’t making a lifetime commitment to either the custodian or the type. You can roll over account assets to a new custodian, or sometimes even into an employer’s plan. And you can convert a tax-deferred IRA to a Roth IRA by paying the taxes that are due on any tax-deferred amounts you move. There are no income caps limiting who can convert to a Roth.
While this might seem like a shaky situation, it doesn’t have to be if you plan and invest intelligently. After all, while the money you get from Social Security and your retirement plan are both largely linked to how much you make in your working years, there’s no set limit to what you can invest, and no restriction on how you invest it. This freedom to move—and grow—makes investing in an area where you can make up for the ground you might lose elsewhere.
DOUBLE ADVANTAGE
IRAs offer the flexibility of individual investments combined with the opportunity for tax-deferred growth. A solid IRA investment strategy takes advantage of both these strengths but doesn’t guarantee a profit or prevent a loss.
DO
- Take advantage of the flexibility of RAs to invest in individual stocks and bonds you can’t usually get under an employer’s plan
- Choose investments that have the potential to grow
- Contribute as much as you can early in the calendar year, or at least make regular deposits
DON’T
- Make your choices and forget about them because some are sure to be disappointing and should be changed
- Focus on tax-free investments like municipal bonds if you’ve got a traditional IRA, since all earnings will be taxed, and these investments usually don’t produce as strong a return as other bonds
- Delay until the last possible day (April 15) to make your contribution
